For investors, 2018 will be remembered for the sharp selloff that dominated the fourth quarter, topped off by the worst December for stocks since the Great Depression. Ironically, 2018 was relatively calm until the fourth quarter. Outside of a brief correction in January and February investors focused on an accelerating economy, stronger earnings growth and lower corporate tax rates. Based on economic data and indicator trends, it does not appear that conditions are in place to produce a domestic recession. Simply put, the economy is still experiencing healthy consumption levels, a strong labor market, and still relatively easy monetary policy. While volatility will remain relatively elevated in the new year, especially until we see more clarity around trade policy and other issues, we expect economic and corporate earnings growth to remain good enough to push stock prices higher by the end of the year. Coupled with much more attractive valuations and risks better reflected in many asset prices, we are consolidating investment exposure to our highest conviction stocks, opportunistically bolstering fixed income as a portfolio ballast, and preparing to offset expected volatility with tactical adjustments during periods of strength and weakness.
The S&P 500 did finish in the red for the first time since the end of the global financial crisis. Almost certainly—years don’t tend to repeat themselves and although past performance is certainly no guarantee of future results, history is somewhat in the bulls’ favor, with the S&P 500 declining in back-to-back years four times since 1929. Outside of the US, European markets finished the year in negative double-digit territory, Chinese stocks fell more than 25%, and emerging markets were off close to 15% for the year. The Bloomberg Barclays US Aggregate Bond Index was in negative territory for much of 2018, but advanced in the closing months of the year and actually returned a flat 0.0%. All in all, broad-based asset-price weakness prevailed in 2018, with no major category posting a positive return.
Our view is that the fourth quarter market correction was brought on by three primary drivers. The first is the fear of higher interest rates and inflation. Neither has been moving strikingly higher, but both have advanced over the last 12 months, dampening equity valuations. Second, concerns over slowing economic and earnings growth and trade issues are the most prominent, but investors are also worried about Brexit, the Italian budget stalemate, falling oil prices, political dysfunction and uncertain Federal Reserve policy. Since the concerns have widely been known, the magnitude of the decline was surprising. This brings us to the third driver, that of the evolving market structure. Broadly speaking, there are three types of investors in US equity markets: active investors, passive investors, and short-term traders who often use computer algorithms and momentum strategies to try to generate short-term profits. Over time, passive investors have grown and active investors have shrunk, and the importance of algorithm trading has increased. Once momentum algorithms are triggered, there are not enough active investors, who trade on fundamentals, to stand in their way. This dynamic is amplified during periods of less liquidity and lighter volumes, such as the holidays. However, when these pullbacks are not validated by legitimate deterioration in economic conditions, they do not endure. According to Citi Chief US Equity Strategist, Tobias Levkovich, “Citigroup's Panic/Euphoria model hit panic levels after a massive drop in stock prices last month. This indicates high probabilities of making money (with average 18% upward moves looking out 12 months)." The Panic/Euphoria model has had a good track record of predicting pullbacks and surges, reaching "euphoria" levels in 1999 before the dotcom bubble burst in 2000, "panic" levels back in 2016 before the big post-election rally, and “euphoria” levels to end 2017.
Just knowing that volatility in the stock market is not only possible but probable can often help investors stay in the right mindset when it actually occurs. Market corrections are a normal part of the investment process, and even more common particularly late in the business cycle. The best way we can help you prepare for volatility is by having an investment plan in place that matches your goals and values, being clear about the risk level that encompasses an appropriate mix of stocks and bonds, and then helping you stick to that plan. An established investment plan gives you a decision framework to help keep your head even when markets get choppy. History has a way of calming our nerves especially as we face times of volatility. Looking back on how the markets historically reacted can bring insight and peace of mind. It is during these times that it becomes most important to stay focused on the long-term and not let headlines cause panic and actions based on impulse.
Although disruption creates risk, it can also generate potential opportunities for investors with a disciplined strategic approach. Fortunately for investors, the overall economic backdrop is not as dire as recent media headlines suggest. While recent selling pressure was rooted in valid uncertainties, global economic fundamentals imply high single digit corporate earnings growth in 2019. As of this writing, over 75% of Q4 2018 earnings reports have beat their estimates. Most importantly, the U.S. economic backdrop remains solid, growing at a real 3.5% annualized rate in the third quarter. In addition, the labor market remains strong with the December nonfarm payrolls report showing an above consensus 312,000 jobs created, wages were up 3.2% year-over-year, and we witnessed the best holiday season we have seen in the last six years. Full year 2018 earnings and revenue growth came in at the highest rate (22.6%, 8.9%) since 2010 and 2011, respectively. Meanwhile, all 11 sectors are forecasted to post positive growth in 2019, albeit at slower rates.
Solid earnings went largely unrewarded in 2018 as valuations compressed back in line with post-crisis averages in developed markets, offering better compensation for risk in 2019. Due to the selloff, forward price-to-earnings (P/E) ratios for US equities have fallen by the most in a year since 2009. Current levels now sit in the bottom 33rd percentile over the past 30 years. Outside the US, valuations are even more attractive, with price-to-earnings ratios in the bottom 10th percentile, on an absolute and relative to the US basis over the past 25 years. Bonds are looking more attractive as well, both as a source of income and as portfolio ballast against any late-cycle growth scares. Short-term Treasuries now offer almost as much yield as the 10-year Treasury, with one-fifth of the duration risk. We are optimistic, given that lower valuations typically imply higher future returns.
Investors are probably going to remain on edge until an actual solid trade deal between the United States and China is reached. Other geopolitical issues are also worrisome, such as the US government shutdown and messy Brexit possibility contributing to uncertainties. To be sure, increasing uncertainty (primarily around rising trade tensions) has been a major drag, offsetting robust fundamentals. The risk is a further escalation that disrupts global supply chains, pressures corporate margins and hurts market confidence. In the meantime, we expect the Fed to pause rate hikes for at least the first half of the year, which should have a calming effect on the markets. A resolution to these lingering political concerns would likely help to re-establish animal spirits, accelerate capital spending and likely send stocks higher.
While trade-related uncertainty and fears of a slowdown remain in forefront, a US recession is not yet on hand. Recession probabilities are low for 2019 but rising to just above 50% by the end of 2021. Of course, there are certain economic and political events that could actually postpone a recession and prolong the bull market, such as a bipartisan domestic infrastructure package. In the meantime, we will prepare by shifting to more defensive allocations over time in order to dampen volatility, and continue to opportunistically invest in our favorite stocks, sectors, and income-oriented option strategies. We will remain disciplined around diversification and likely enact more frequent rebalancing to take advantage of overbought and oversold ranges.